Options are quite different from forwards and futures since the holder of an option has the right, but not the obligation, to buy or sell an underlying asset. Also the option buyer must pay the option seller for this right or option at the beginning of the contract.
A call option gives the holder the right to buy at a pre-specified price (called the exercise price, strike price or striking price) and a put option the right to sell at the exercise price. For example, the owner of a call option has a choice whether to exercise the option or not. Whatever they do they pay the price of the option (the option premium) and if they decide to exercise the option they must pay the exercise price to the option seller in order to buy the underlying asset. On the other hand the seller, or writer, of the call option keeps the premium but is obliged to sell the underlying asset to the option holder if he decides to exercise the option.
An option has an expiry or expiration date, and an option that has not been exercised by this date expires worthless. If the holder of a call option decides to exercise he must pay the exercise price and will be delivered the underlying asset or an equivalent cash sum. If the holder of a put exercises the option he will deliver the underlying asset, or cash equivalent, and receive the exercise price.
Options can be traded on exchanges or over-the-counter. Note that if they are dealt over-the counter, the credit risk is unilateral since only the option writer can default.
The most common exchange traded options in the U.S. are stock options, index options, foreign currency options and options on futures.
An American option can be exercised at any time prior to or at expiration, a European option at expiration only. So for equivalent options, an American option is worth more, since in certain situations it may be advantageous to exercise the option prior to expiry.
A call option is in-the-money if the stock price is higher than the exercise price, out-of-the money if the stock price is lower than the exercise price and at-the-money if the stock price is equal to the exercise price (and the opposite holds for put options). Options that are far in-the money are called deep-in-the-money and far out-of-the-money are called deep-out-of-the money.
The value of a call option at expiry is either zero or the stock price (S) minus the exercise price (X). This is the intrinsic value of the option, the value of the option if it was exercised immediately. If the intrinsic value is positive, the option is in-the-money. If it is zero then the option is out-of-the-money or at-the-money.
A put option will have a value at expiration of Max [0, (X– S)]; this is the intrinsic value. Prior to expiration an option will usually trade at a market price above its intrinsic value. The difference between the price and the intrinsic value is the time value.
These are customized contracts (price, exercise price, time to expiry etc are decided by the two parties), and the parties are usually institutional rather than retail investors. The option buyer runs the risk the writer will default, and sometimes will require collateral. The markets are essentially unregulated.
The exchange standardizes all the terms of the option contract; only the price is decided by the participants. Usually there are options available with an exercise price close to the trading price of the underlying asset. The exchange decides which companies (in the case of stock options) will be listed for options trading. The participants in the exchange are usually either market makers or brokers.
As in the case of futures, the transactions are guaranteed by the clearing house. The clearing house also has to protect itself against the writers defaulting so the premium paid is deposited in the option writer’s margin account and the writer must deposit additional money in the account.
The amount will depend on whether the option is in or out-of-the money and whether the writer has hedged the risk.
Since the contracts have standardized terms, an option holder can go to the market and sell the same contract and the positions will be cancelled.
Generally at expiry an in-the-money option will be exercised and out-of-the-money options will expire unexercised. Most exchange-traded options require actual delivery of the stock rather than cash settlement; in this case the decision to exercise will take into account the transaction costs involved with trading the stock or settling in cash.